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How does one select a mutual fund? The Indian mutual fund industry has come a long way, with the assets under management (AUM) growing at an annualised rate of 20% between September 2006 and September 2009. It has moved from offering traditional equity and debt schemes to specialised products, such as funds of funds, arbitrage funds, asset allocation funds and exchange traded funds (ETF). All these make it difficult for investors to select the scheme that suits their needs.
Let us look at some of the parameters that should be considered while selecting funds.
Investment objective & risk profile: The investment goal of the fund must coincide with that of the investor. The objectives can be defined in terms of tax planning, regular income, high returns, long-term planning, etc. Equity funds are more tax-efficient compared with debt funds, short-term debt funds aim at regular income, whereas closed-ended equity funds aim at long-term capital appreciation.
The fund should be chosen according to the investor's risk tolerance. The objective of high returns is generally associated with high risk. The Association of Mutual Funds in India (Amfi) defines three types of risk tolerance levels: low risk or cautious, moderate risk or cautiously aggressive, and high risk or aggressive.
Low-risk investors should consider debt funds, which invest in government securities or high rated debt papers. Moderate-risk investors should consider index funds, balanced funds and asset allocation funds. High-risk investors should look for equity funds (diversified and specialised), offshore funds and mid-cap funds.
Fund performance & management: Though the past performance of a fund does not define its future performance, it is important to consider how it has performed with respect to its benchmark or other similar funds. A fund should be compared with the same category of funds. So, the performance of a mid-cap fund cannot be compared with that of a large-cap fund as the former is more volatile compared with the latter.
Past performance also helps in assessing the quality of fund management, the skills of the fund manager and his team. The stock picking and market timing abilities of the manager can be judged by comparing the fund performance with its benchmark. The funds that perform better than their benchmarks are considered outperformers, whereas the funds that yield less than their benchmarks are underperformers.
Fund size: The size is important because a very large fund often faces difficulties in the optimum deployment of its corpus, which, in turn, negatively impacts its performance. On the other hand, a very small-sized fund is constrained with the problems of high costs. Therefore, one should go for a mid-sized fund as it ideally balances the investment flexibility and costs.
Fund costs: These involve the operating costs of running a fund and include marketing and selling expenses, audit fees, custodian fees, etc. These costs can be gauged by looking at the fund's expense ratio, which is reported in its annual report. The expense ratio should be compared with similar funds as those with high ratios significantly impact the long-term investors due to the effect of compounding.
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